High earners at risk of £65k retirement shock

Only 43% of households are on track for an adequate retirement income – and the highest earners could face the biggest shock of all.

Top-quintile earners could face a pension shortfall of £64,750 if they maintain their current lifestyle in retirement, according to analysis from investment platform Hargreaves Lansdown. This falls to a shortfall of just £1,250 among low-income households in the bottom quintile of earners.

This suggests low earners are better prepared for the transition into retirement, despite having smaller pension pots.

MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

It largely comes down to different lifestyle costs. Those on low incomes tend to spend less, meaning the state pension can go a long way towards covering their living expenses. It is less likely to stretch to more luxurious lifestyle choices, though, with the full new state pension currently coming to £11,973 per year.

Cost of a basic, moderate and comfortable retirement

The annual cost of a basic retirement is £13,400 for a single person and £21,600 for a couple, according to figures from trade association Pensions UK. This figure rises to £31,700 for a single person seeking a moderate retirement, and to £43,900 for a couple. Those seeking a comfortable retirement need £43,900 (single person) or £60,600 (couple) respectively.

Hargreaves Lansdown has not based its analysis on these figures, but on a different benchmark – an adjusted version of the Pension Commission’s target replacement rate, with a floor derived from the Living Wage Pension. A target replacement rate is where you save enough to give you an income that hits a specific percentage of your pre-retirement salary – for instance two-thirds.

The investment platform said this benchmark is a better measure of a household’s ability to maintain its standard of living after quitting the workplace. Meanwhile, the pounds-and-pence measures used by Pensions UK “assess households on their ability to hit a specific target income, regardless of what their pre-retirement lifestyle has been”.

Hargreaves Lansdown’s benchmark paints a stark picture for high earners. It shows only 40% are on track for a moderate income in retirement, compared to 52% based on the Pensions UK benchmark.

“It’s an important issue, as the government looks more closely at adequacy in the pension system,” said Helen Morrissey, head of retirement analysis at Hargreaves Lansdown.

“Increasing auto-enrolment minimum contributions would undoubtedly help higher earners to bridge the gap to pension adequacy,” she added, “but is it fair to expect lower earners to also accept the hike when they may already be struggling in the here and now and already be close to achieving adequacy?”

Morrissey believes some thought needs to be given to how to incentivise higher earners to contribute more.

How much do you need for retirement?

Working out how much money you need to retire can be challenging. The figures from Pensions UK give some rough guidelines on how much a basic, moderate or comfortable retirement might cost you each year, but there are still lots of unknowns.

Nobody knows how long they will live. Many of us are now living into our 90s – and costs can ramp up in later life due to things like care fees. It is also difficult to account for economic shocks. High inflation pushed retirement costs up rapidly in the aftermath of the pandemic, eroding the purchasing power of retirees’ savings.

How far your savings will stretch also depends on your standard of living. Higher earners who have enjoyed life’s luxuries while working are unlikely to want to give them up when they retire, meaning they probably need to build a bigger pension pot.

Hargreaves Lansdown’s analysis suggests those in the bottom quintile of earnings while working (i.e. on a salary of less than £18,900) should aim for a target replacement rate of 86%. This means they should look to generate an annual pension income of up to £16,254.

Meanwhile, those in the top quintile (earning over £79,600) can aim for a lower target replacement rate of 50%, which would mean an annual pension income of £39,800+.

We plugged the figures into Aviva’s annuity calculator, which showed a 65-year-old may need a pension pot of around £735,000 to buy an annuity that generates this much in annual income (i.e. to meet the needs of the higher earner). These calculations assume the pensioner buys the annuity after taking their 25% tax-free lump sum (worth £183,750).

Of course, this is just an estimate. The exact amount you need also depends on other considerations, like whether you own your property outright or still face housing costs like mortgage repayments or rent.

Not everyone decides to swap their pension pot for an annuity either. Many opt for other strategies like drawdown, where a lot will depend on the performance of your underlying investments.

Financial resilience improves when non-pension assets are considered

Many savers will be able to supplement their retirement income with wealth from non-pension assets, helping bolster their financial resilience. More than two in five households (42%) report holding some form of non-pension investment, according to Hargreaves Lansdown.

“The self-employed – who typically have much lower pension adequacy scores compared to employed households – experience the largest gains when these additional assets are factored into our pension adequacy assessment,” Morrissey said.

Forty-seven percent of self-employed households would reach retirement adequacy using this measure, compared to 36% if just pensions were used. This is because some self-employed households are reluctant to put money into a pension, as they know they won’t be able to access it until they turn 55.

“We have long championed the use of the Lifetime ISA for this group,” Morrissey said. “The 25% government bonus acts in the same way as basic-rate tax relief on a pension and income can be taken tax free. Importantly, money can be accessed in an emergency subject to a 25% exit penalty.”

She thinks the Lifetime ISA could be made even more attractive by expanding the current age criteria beyond the age of 40 and reducing the exit penalty to 20%.